Guest Post: The Investment Everybody Loves to Hate

If Wishes Were Horses …

Imagine a stock - best for the hypothetical exercise is probably a tech stock - rising for 12 years without interruption. A net gain every year, sometimes a small one, sometimes a bigger one, but nicely compounding at an annual yield of more than 17.13% (that's a devilish 666.67% in 12 years).

What would people say about this stock? Would there be a steady stream of negative press trying to dissuade people from buying it? We somehow doubt it, although almost every investment that has seen a great deal of appreciation has its detractors (and sometimes they are right).

When it comes to gold, one could certainly debate the merits of buying it at what appears at least on the surface as a high price. Gold bulls can only profit from examining bearish arguments, in order to see if they have merit.

So we always take a look around to see if any tenable bearish argument is put forward, but so far we very often get to see what might be termed 'tortured logic'. When the gold market sold off a little in the wake of the helicopter pilot announcing even more money printing, one of the bears seized the moment to opine as follows:

“Long-term and perhaps even short-term investors of gold could be forgiven for getting rattled on Thursday as the precious metal dropped below $1,700 an ounce down over $26 in the early hours of U.S. trading.

Get used to it, says Uri Landesman, president of Platinum Partners, a New York-based multi-strategy hedge fund. ”Gold was overvalued and it’s going to come down dramatically,” he said. And he sees 2013 shaping up as a year where gold will trade in a range of $1,400 and $1,800, meaning current prices are on the high side.

“The Fed is pretty much saying that we’re going to backstop the stock market forever,” said Landesman, referring to the Federal Reserve’s prior-day declaration that it wants unemployment in the U.S. — currently at 7.7% — to drop to 6.5% before it raises interest rates again. And backstopping equity markets more or less indefinitely is not good for the precious metal, he said.

“Gold tends to do best if there’s a flight to quality. That’s not the case right now because the Fed is being so accommodative and saying we’ll be propping up gold until unemployment gets to 6.5%. That’s a sharp signal that there’s no reason to fly to gold, because gold is overvalued here.”

We'll take this step by step. First of all, any 'long term gold investor' who 'gets rattled' by a $26 move lower should probably go on vacation or think twice about investing in anything at all. Just saying.

Contrary to Mr. Landesmann we don't purport to know whether gold is 'set to correct dramatically'. It might, but then again, it might not. The fact that we hear this every year and it has yet to happen is of course no guarantee that it won't happen this time around. So why is it supposed to happen? Landesmann says gold is 'overvalued', but since he doesn't supply any reasoning with that statement, we'll have to just let it slide. Still, one wonders how he has determined what the 'correct' value is.

But then we are getting to the 'tortured logic' part. “The Fed is pretty much saying that we’re going to backstop the stock market forever,” Landesmann avers. The stress really should be on 'pretty much' here, since the Fed has said no such thing anywhere. If it has, we must have missed it (it was neither in the FOMC statement nor in Heli-Ben's press conference). This is basically where the 'wishes and horses' come in (for detailed advice on how to become a horse, see here. Blücher!)

One could perhaps say that one suspects the Fed of wanting a rising stock market, and one would probably be correct about that. In fact, it is a good bet that it wanted a rising stock market for the past four years, and it actually got one. Already nearly two years ago, on occasion of 'QE2', Ben Bernanke let it slip that he regarded the rise in the Russel index as one of the marks of the success of his policy. Rising commodity prices by contrast of course had absolutely nothing to do with his money printing; that's always been China's fault, similar to all other bad things, such as the US housing bubble. That was also China's fault, natch, because these evil people save too much.

The reality of the matter is though that the central bank cannot control where the money it creates ultimately goes and which asset classes will be preferred by investors.

Imagine someone pondering whether to invest in a few shares or a bar of gold. The following thought is highly unlikely to be first and foremost on his mind: “Wait a minute! Before I push that buy button let me think about what Bernanke wants me to buy! Wouldn't want to do anything overly hasty here!”

Again, the only thing the Fed admits to wanting to 'prop up' are not equities, nor gold, or any other specific investment asset besides bonds (obviously it is buying bonds with the aim of artificially suppressing interest rates); its declared aim is to prop up 'economic activity' in the hope that this will lower the rate of unemployment. It does so by trashing the currency it issues, which has been a time-honored method since the time of Roman emperor Diocletian and has never worked in all of history, which evidently hasn't kept people from attempting it over and over again (a form of insanity, if you will). So the only thing we can really say is: “The people in charge of monetary policy are either extremely misguided or downright insane. Place your bets accordingly”.

A More Balanced Discussion

It was perhaps unfortunate timing to publish an article entitled “Gold Surges in Popularity, but Is It Stuck Without an Ever-Easing Fed?” within a day or two of the FOMC announcing 'QE4' (the numbering may be superfluous, as it seems to be part of 'QE-Forever'). However, the article by Michael Santoli at least adopts a neutral tone and seems mainly to be concerned with discussing the metal's investment merits dispassionately. It seemingly takes no position on the question whether gold is, or rather should be, money, although it cannot keep from adding a few barbs with regard to that point. After all 'gold bugs' apparently stand forever accused of pining for a 'barbaric relic' to be reinstated as money, which is clearly a no-no, since we have this much better 'flexible' and 'scientific' monetary system in place today that works so well that it produces major bubbles and system-threatening crashes with unwavering regularity. Who would want to do without all that excitement?

Anyway, Santoli makes a few interesting points that are worth pondering. He notes for instance that e-bay is getting in on the act:

“Major online retailer eBay (EBAY) has recently launched a popular venue where individuals can buy gold bullion and coins. This is noteworthy in at least two — somewhat contrasting — ways.

As a matter of consumer experience and business strategy, the creation of the APMEX Bullion Center on eBay marks real progress. Few markets are as fragmented or confusing to navigate as the one for physical precious metals, dominated by small dealers and shrouded in opaque pricing. The seal of eBay's approval placed on APMEX, an established seller of bullion and coins, makes this an attractive destination for metals buyers, as does the firm's transparent, real-time pricing and the extension of eBay's buyer-protection policies.

Yet the very fact that this is a large enough market to tempt eBay — a company worth $66 billion and boasting $12 billion in annual revenue — offers yet another occasion to ask whether the decade-plus bull market in gold prices is nearing an end phase, in which broad popularity comes just as the key drivers of pricier gold may have peaked.”

(emphasis added)

It is certainly true that one should keep an eye out for anecdotal evidence that something is becoming 'too popular' (on the theory that this would be a contrary indicator). However, thinking about this a bit, it does not appear to us that gold is already at what deserves to be called a peak of popularity. The percentage of investment assets dedicated to gold remains at a paltry level, far below of what it once was. Estimates range from 0.2% to 0.8% of all investable assets being dedicated to gold and gold-related investments. These are not exactly numbers likely to raise alarm among contrarians. As to the question of whether the 'key drivers' of gold have peaked, a 'peak' by definition can only occur once, so it is always difficult to judge in real time. Let us just say that the fundamentals as they currently stand continue to look bullish. Since there are not only no signs whatsoever that the above mentioned global race to currency oblivion (the Fed is not the only central bank issuing money by the truckload) is over – rather the opposite in fact – there seems to be no reason as of yet to ruminate about whether this 'peak' has occurred. Besides, by the time the bull market does near its end, gold probably will be extremely popular.

Santoli then makes a valid point, namely that gold is no longer a bargain. Of course, back when it still was a bargain, very little was written about that fact either, but that doesn't change the fact that it no longer is one. He writes:

“The broader investment case for gold, though, must address whether a market that has seen prices rising for more than a decade, and is now pulling in a broader assortment of less-informed investors, can continue much higher at a time when the metal is relatively expensive compared to an array of other assets.

While gold, in dollar terms, has doubled since the financial crisis sent world central banks creating some $8 trillion in new paper currency, it has been unable to notch a new high since soon after the Federal Reserve's QE2 bond-purchasing program ended in the summer of 2011. Its lethargic price action lately has implied little market expectation of more assertive Fed easing, after this week's policy meeting or any time soon.”

The first paragraph is correct – gold has risen against an entire array of assets, it has outperformed just about everything. It should be pointed out though that this is what tends to happen during secular downturns. Gold reflects an increase in the demand for money, even if it is not used as a medium of exchange today. However, one can still save in gold – in the knowledge that it cannot be printed by any central bank. That remains its chief attraction. How far the increase in gold's value relative to other assets will go is unknowable. We can at best try to come to conclusions from looking at the history of e.g. the Dow-gold ratio to name a popular yardstick, but obviously this does not amount to a guarantee that things will play out on a similar manner again. Gold may rise less than last time around, but it may also rise even more. This will depend on the value scales and states of knowledge possessed by investors in the future, which are inherently uncertain.

As to the remark about there having been 'little market expectations of more assertive Fed easing', if those were indeed evident, then they were obviously mistaken, because 'more assertive Fed easing' is precisely what was delivered.

Santoli concludes along similar lines:

“Indeed, the charts of gold against industrial commodities and median home price tell the story of its monetary worth reasonably well, with the metal taking off to the upside in 2008 as the financial crisis created a rush for enduring havens for wealth rather than "usable" goods.

With gold already reflecting plenty of safe-haven, money-of-last-resort, store-of-wealth value, gold bulls who argue for much higher prices need to rely on the idea that the crisis-spawned money printing will escalate and produce more inflation and financial instability than is already anticipated. This is a plausible position. But it will become a tougher case to make in the near term as Western and Asian economies continue their gradual recovery and the Fed moves incrementally rather than launching zealous new asset-buying plans.”

(emphasis added)

Now, we already know that 'incremental' Fed moves are out of the window as completely as they could be at this juncture (we think that eventually, things will become even more crazy. If you want to know more about Bernanke's future shopping list, consult his 2002 speech on 'deflation').

That leaves the question Santoli poses above: namely whether “the crisis-spawned money printing will escalate and produce more inflation and financial instability than is already anticipated.”

To this one need only keep one thing in mind: it is not just the case that the 'money printing' has been 'crisis spawned', but that the money printing (unless stopped very credibly and forcefully before things get out of hand) by itself is absolutely certain to spawn yet another crisis. After all, the initial crisis was also the result of too much money printing. In the 2001-2002 recession, the annual growth rate of the broad US money supply measure TMS-2 at one point exceeded 21%. Why would anyone assume that even bigger doses of the very same policy will have more beneficial effects? There is neither a credible theoretical nor a historical case to be made that argues in favor of holding such a belief.

It is also very important to keep in mind in this context that there can be enormous lag times between the implementation of such a policy and the inevitable appearance of its negative effects in a manner that makes them obvious to all and sundry. We regularly quote a passage from Human Action here in which Mises points out that an inflationary policy can go on for many years without anyone suspecting harm – but it cannot go on forever.

Finally, there is a historical datum of interest in the context of major secular bull markets (a bull market that has been in force for 12 years qualifies as such): they neither end with a whimper, nor do they end while the fundamentals remain supportive. The final phase of almost every major bull market is characterized by two essential features: 1. the rate of the price increase accelerates (prices 'go parabolic') and 2. the supportive fundamentals disappear (usually, interest rates are rising. To name a few prominent examples: this happened with the Nikkei in the late 80's, with gold in 1979/80, with the Nasdaq in 1999/2000). It is of course possible, even likely, that there will be a major correction in the gold price before this phase commences. In fact this is also something that has also been observed in the examples we have listed (the Nikkei's final major pre-blow-off correction was in 1987, the Nasdaq's in 1998, gold's in 1975/6). Richard Russell briefly talks about this phenomenon here.

Technical Conditions

The fund manager quoted above also mentioned technical evidence that allegedly indicates a growing likelihood of a bigger correction. We don't see it, at least not yet. Rather, it looks like gold remains in a normal consolidation. On the weekly chart depicted below, we have indicated the major areas of lateral support (blue dotted lines) and resistance (red dotted lines). As long as prices are between these levels, the chart remains neutral. Should one of these levels be broken, then one can reasonably argue that a technically significant change has occurred, but not before.

To us the chart actually looks bullish, since most of the time, drawn out multi-month consolidations of this type turn out to be continuation formations. However, there can obviously be no guarantee of that – we will have to wait and see. What we can say though is that should the indicated support level break, then obviously a deeper correction will be underway and one would have to take a look at lower support levels (there are several price congestion areas that are candidates for such). Conversely, a break-out above resistance would likely lead to a rally the size of which correlates in some manner with the length and breadth of the preceding consolidation.